Thousands of music videos pulled from YouTube in a royalties dispute will go back online after peace broke out today between the website and the music industry.

A new licensing deal with PRS for Music, the trade body that collects music royalties, has brought the six-month dispute to an end.

It began when YouTube accused the PRS of proposing exorbitant new payment terms and led to the website fending off criticism from the PRS, which felt it was punishing British music fans by removing videos in the quest for greater profits.

Thousands of music videos are now being reinstated after being blocked from the site by YouTube's parent company Google during the licensing wrangle.

But while this conflict has been resolved, another dispute has erupted over the digital future of the music industry.

A rift has opened between music's creators and its record labels, with a broad alliance of musicians, songwriters and producers fiercely criticising the business secretary Lord Mandelson's plans to cut off the broadband connections of internet users who illegally download music.

In a statement seen by the Guardian, a coalition of bodies representing a range of stars including Sir Paul McCartney, Sir Elton John and Damon Albarn attacks the proposals as expensive, illogical and "extraordinarily negative".

The plans have already been attacked by privacy campaigners, internet service providers and a range of MPs, some of whom accuse the business secretary of being influenced by secret meetings with senior figures from the music and film industry, a charge he denies.

The coalition accuses the government of being backward looking, saying there is "little support from logic" in proposals to cut off file sharers – a move welcomed by the record companies and UK Music, the umbrella body for the entire industry.

The statement says: "We vehemently oppose the proposals being made and suggest that the stick is now in danger of being way out of proportion to the carrot. The failure of 30,000 US lawsuits against consumers and the cessation of the pursuit of that policy should be demonstration enough that this is not a policy that any future-minded UK government should pursue."

There has been an explosion in file sharing in the last decade, with albums being swapped hundreds of thousands of times over the internet – Lady Gaga's The Fame was swapped 388,000 times on P2P site Pirate Bay within seven days of its release. But there is little agreement in the music industry about how the problem should be tackled.

The BPI, the body representing record labels, argues that the UK's 7 million file sharers cost the industry an estimated £200m a year and called Mandelson's proposals "a step forward".

But Patrick Racklow, the chief executive of Basca, said those involved in music had to look for new ways of licensing new music technologies, rather than fighting them. "The problems the music industry faces will not be dealt with effectively through legislation," he said. "We can't support these proposals because we don't think it will work, it will cost too much and is far too blunt a tool."

Research suggesting that people who file share also buy more music provided hope, he said. "The music industry is quite a scary place to be at the moment and we don't know what it will look like in 10 years' time, but if we find ways of licensing, new ways of doing things will evolve. What we can't do is try to push things forward by looking back."

Deals such as the one struck between YouTube and PRS, as well as licensing agreements with music-streaming websites such as Spotify and We7, may provide light at the end of the tunnel for the industry, proving that compromises can be made if consumer demands are considered.

Patrick Walker, YouTube's director of video partnerships, said the dispute had been regrettable, but that the service was committed to building relationships with the music industry. "This deal provides a positive example that people can come together with the objective of satisfying user demands," he said. "It is a very fast-moving area and we need to make sure we don't retrench but remain flexible so that everyone can benefit."

Andrew Shaw, the managing director of broadcast and online at PRS, said the organisation was delighted that music videos were back on YouTube. "We hope it is the first of many deals with other services so that music can get out there in whatever way people want to listen to it, while making sure our members get paid," he said.

Both organisations were vague about the agreement, but music industry analyst Mark Mulligan, vice-president of Forrester Research, said the disclosure that a lump-sum deal had been reached suggested the terms were more favourable to YouTube than PRS.

The YouTube deal and the musicians' condemnation of plans to prosecute file sharers were indicative of the fundamental power shift happening in the music industry, he said.

"We are in a period of transition, and traditional business models are being reassessed," he said. "The position of the record labels is inherently weaker because of the falling value of recorded music and that gives the other people in the equation, including artists, managers and producers, more power. What we are seeing here is those players flexing their muscles, which is only possible because the record labels are weakening."

Sound and fury: industry's uphill struggle

In 1999 the music business was booming, CDs were flying off the shelves and, even if the Backstreet Boys were at the top of the charts, the music industry felt like a good place to be. Few people were aware that at the Northeastern University in Boston student Shawn Fanning was creating an online music file sharing service that would transform the music landscape forever. Napster – as the service was called – allowed people to easily share their MP3 files, cutting out the record labels and paying little heed to copyright. For a music industry which had long complained that home taping was killing music, this was devastation of a different order.

Napster was soon followed by similar websites KaZaA and Gnutella and, as the potential of filesharing to undermine the record sales became clear, the music industry's reaction was quick and brutal.

In 2001 Napster was shut down by a US court order, but it had paved the way for other peer-to-peer file-sharing programmes, which continue to plague record labels today. A year later Apple's iPod was launched, instantly allowing music fans to carry hundreds of albums with them in digital form. It was followed in 2003 by the launch of the iTunes store, providing a legal online store for people to buy digital music. It was arguably too late. Profits were plummeting, and by 2007 British album sales had dropped 10.4% on the previous year.

In 2004 global revenue from CD and DVD sales was around $32bn (£20bn), by 2008 that had dropped to $22bn and by 2012 it is expected to drop to about $11bn.

New ways of getting music online began to appear. MySpace debuted in 2004, providing a new platform for bands to interact directly with fans, allowing them to post music that could be listened to instantly. In the same year, digital single sales surpassed physical single sales for the first time. In 2008 Spotify, a legal ad-funded online streaming service, was launched allowing music fans to listen to hundreds of thousands of tracks and albums instantly, and for free.

Video games like Guitar Hero, released in 2005, began boosting music sales for some artists. As CD sales continue to fall today artists are making more money than ever from concerts – figures from PRS for Music revealed that UK music tour revenues increased by 30% last year. As a result, record labels are increasingly trying to sign artists on "360º contracts" that take a cut of merchandising, live music, and sponsorship deals.

The industry continues to look for new ways to make money in the digital age. In June the cable company Virgin Media announced the launch of an unlimited download service in partnership with the world's largest music company, Universal, which would allow subscribers to stream and download as many tracks as they want for £10-£15 a month.